Fin 4201/8001 Topic 3: The Toolbox

Buffett’s toolbox Business tenets Business tenets Management tenets Management tenets Financial tenets Financial tenets Market tenets Market tenets

Business tenets Three basic characteristics of the business itself Three basic characteristics of the business itself Is the business simple and understandable? Is the business simple and understandable? Does the business have a consistent operating history? Does the business have a consistent operating history? Does the business have favorable long-term prospects? Does the business have favorable long-term prospects?

#1 – Simple and Understandable Invest within your circle of competence Invest within your circle of competence Size of circle is not important, but how we define the parameters Size of circle is not important, but how we define the parameters Understand revenues, expenses, cash flow, labor relations, pricing flexibility, and capital allocation needs Understand revenues, expenses, cash flow, labor relations, pricing flexibility, and capital allocation needs Success comes from doing ordinary things exceptionally well Success comes from doing ordinary things exceptionally well

#2 – Consistent Operating History Smooth increases in growth Smooth increases in growth Profits without substantial capital infusions Profits without substantial capital infusions AVOID AVOID Trying to solve difficult problems Trying to solve difficult problems Changing directions Changing directions Look for one-foot hurdles and step over them rather than looking for seven-foot hurdles Look for one-foot hurdles and step over them rather than looking for seven-foot hurdles

#3 – Favorable Long-Term Prospects Nature of business? Nature of business? Commodities – product same as competitor Commodities – product same as competitor Franchises are better, but perishable Franchises are better, but perishable Product needed or desired Product needed or desired No close substitutes No close substitutes Not regulated Not regulated Pricing flexibility = increased ROE Pricing flexibility = increased ROE Stronger franchises are better Stronger franchises are better

Management Tenets Three qualities that senior managers must exhibit Three qualities that senior managers must exhibit Is management rational? Is management rational? Is management candid with shareholders? Is management candid with shareholders? Does management resist the institutional imperative? Does management resist the institutional imperative?

#4 – Rationality Capital allocation = Earnings = distribute or retain Capital allocation = Earnings = distribute or retain Reinvest – one dollar premise Reinvest – one dollar premise Buy Growth Buy Growth Return to shareholders Return to shareholders Dividends Dividends Share repurchases Share repurchases When looking at firm how do today’s actions compare to prior years vision When looking at firm how do today’s actions compare to prior years vision

#5 – Candor Report the company’s performance correctly and completely Report the company’s performance correctly and completely GAAP is only the beginning GAAP is only the beginning “Look-through earnings” “Look-through earnings” Admit mistakes Admit mistakes

Sidebar on Accounting Understand what the numbers “mean” Understand what the numbers “mean” Intrinsic value = discounted value of cash that can be taken out of business over life. Intrinsic value = discounted value of cash that can be taken out of business over life. Smooth earnings or “big bath” Smooth earnings or “big bath” Report economic goodwill (in addition to GAAP) Report economic goodwill (in addition to GAAP) Depreciation vs. amortization Depreciation vs. amortization

#6 – Institutional Imperative The pitfalls The pitfalls Resistance to change Resistance to change Poor projects and bad acquisitions Poor projects and bad acquisitions Obsequious (yes-men) on the team Obsequious (yes-men) on the team Mindless imitation of peers Mindless imitation of peers

Financial Tenets Focus on ROE, not on EPS Focus on ROE, not on EPS Calculate “owner earnings.” Calculate “owner earnings.” Look for companies with high profit margins. Look for companies with high profit margins. One dollar premise One dollar premise

#7 – Return on Equity (ROE) EPS is in dollars and grows with retained earnings EPS is in dollars and grows with retained earnings “adjusted” ROE = operating earnings/SH equity “adjusted” ROE = operating earnings/SH equity Value marketable securities at cost Value marketable securities at cost Ignore unusual items Ignore unusual items Watch out for leverage (debt) Watch out for leverage (debt)

#8 – Owner Earnings Net Income Net Income  Depreciation  Depletion  Amortization  Capital expenditure  Additional working capital = Owner earnings

#9 – Profit Margin Managers should always be cost conscious Managers should always be cost conscious Investors should be conscious of margin of safety Investors should be conscious of margin of safety

#10 – One Dollar Premise One dollar of retained earnings should lead to one dollar increase in shareholder wealth One dollar of retained earnings should lead to one dollar increase in shareholder wealth Quick and dirty – Increase in market value should be at least as much as retained earnings Quick and dirty – Increase in market value should be at least as much as retained earnings

Market Tenets What is the value of the business? What is the value of the business? Can the business be purchased at a significant discount to the value? Can the business be purchased at a significant discount to the value?

#11 – Value Project future “owners earnings” Project future “owners earnings” Discount these earnings by an appropriate discount rate Discount these earnings by an appropriate discount rate Buffett looks for firms with predictable earnings and then discounts at long term risk-free rate (30 year t-bond) Buffett looks for firms with predictable earnings and then discounts at long term risk-free rate (30 year t-bond)

#12 – Attractive price Buy when price is well below value Buy when price is well below value The higher the discount, the greater the margin of safety The higher the discount, the greater the margin of safety

Coca-Cola Essential Buffett steps through the evaluation process. Essential Buffett steps through the evaluation process. I won’t replicate it here I won’t replicate it here Reread it a couple of times to see how tenets fit and to make sure you understand where the numbers came from Reread it a couple of times to see how tenets fit and to make sure you understand where the numbers came from

Pull all twelve together Circle of competence Circle of competence Margin of safety Margin of safety Good outlook Good outlook Good management Good management Fiscally responsible Fiscally responsible Value < price Value < price Next time – some other tools (Topic 4) and no reading. Next time – some other tools (Topic 4) and no reading.